Our Outlook for Consumer Cyclical Stocks
Amid signs of economic stabilization, several yellow caution flags still wave for the consumer cyclical sector.
Some Positive Signs, But Still Plenty of Yellow Flags
For some time we've held the position that the macroeconomic recovery following the Great Recession of 2008-2010 would be relatively slow and, at times, volatile. Thus far in 2012, we've been encouraged by the recent drop in U.S. unemployment, the rebound in the manufacturing and service sectors, and normalizing levels of inflation. Despite mixed consumer confidence figures, there have been several signs that demand from U.S. consumers is strengthening, including comments from apparel supplier Li & Fung (00494) that orders in the U.S. are "definitely better than last year."
However, we maintain some caution, as sluggish real wage growth, a still recovering housing market, elevated food and fuel costs, global credit market uncertainty, and a wildcard political environment have us concerned that the market has overshot the true pace of economic recovery. Excluding government-related factors, we generally forecast a mild deceleration in sales and earnings growth across much of our coverage universe against more difficult year-over-year comparisons and the flow-through of higher commodity costs (in the first half of 2012), though evidence of sustainable changes in consumer spending would drive us to revisit our assumptions and outlook.
For better or worse, high-end consumers have really been the driving force behind the recovery following the Great Recession, and we now find ourselves in a situation where the economy has become increasingly more dependent on a fairly narrow group of consumers. Notably, these are individuals that don't have to spend if they don't want to, and if the mood of the big spenders were to become more cautious, the tone of the economic sentiment could change in hurry. With relatively strong market performance thus far in 2012, we've become less concerned about a slowdown in the spending habits of high-end consumers, who tend to take their spending cues from equity and other asset market gains. We've built in modest revenue growth deceleration for many of our high-end names due to difficult comparisons, but we will continue to monitor market trends with the potential to accelerate near-term spending even more than we've currently forecast. That said, a material reversal in affluent consumer spending would not only have an adverse impact on the more discretionary names in our coverage universe, but also likely across much of the broader consumer cyclical sector.
At the lower end of the income spectrum, consumers are just now starting to see signs of a recovery. Lower- and middle-income consumers became an incrementally more meaningful contributor of discretionary spending in the U.S. during January and February, but it still remains to be seen whether these trends are sustainable or whether this demographic will continue to embrace frugality out of necessity. Employment statistics for this demographic have improved, though surging retail gas prices will likely erode some of the purchasing power from these consumers in the months to come. We also have concerns that food costs (which have moderated compared with a year ago but remain well above historical norms), elevated rent costs, and the high number of underwater mortgages could take some of the wind out of the sails from household budgets over the course of the year.
Three Reasons for Muted Margin Expansion
We remain comfortable with our mid-single-digit comparable store sales growth assumption for 2012, which implies a modest deceleration in growth relative to 2011 due in large part to more difficult comparisons. Given that consumer cyclical firms continue to operate under lean cost structures, mid-single-digit comparable store sales trends should be more than enough to generate some selling, general, and administrative expense leverage for most firms in 2012, even with operating margins already sitting at or near peak levels. However, we have some concerns that, ultimately, industrywide margin expansion will be somewhat muted this year (at least compared with 2011) due to increased price competition spurred by industry consolidation, growth and infrastructure investments designed to better position consumer cyclical firms in the years ahead, and persistent raw material cost pressures (at least during the first half of the year).
Generally speaking, we believe margin expansion may start to decelerate for many retailers in 2012 for three reasons: 1) We believe the retail sector is simply over stored, and price-leader Amazon (AMZN) makes the saturation problem worse; 2) retail is no longer fragmented for easy share gains against weaker local or regional players and remains far from a margin-neutral oligopoly structure, so we expect destructive price wars to develop; and 3) households and government deleveraging in Europe and the United States over the next decade.
Retailers have been successful driving better-than-expected store traffic the past year, but it has largely come on the heels of increased promotional activity. In our view, retailers have had little success raising prices since the end of the Great Recession, and we see few signs that consumers (particularly in the lower- to middle-income strata) will become any less focused on value in the months and years ahead. We believe the aforementioned forces create more downside, rather than upside, potential for margin expansion in 2012.
Sensing these competitive pressures, most consumer cyclical firms have responded by reinvesting in channel diversification strategies, infrastructure and supply chain investments, and renovation of customer-facing assets. Growth in online and mobile device sales continues to be a solid source of revitalization for mature retailers, most of which have seen year-to-date online sales increase at least in the high-teen to low-20% range (though largely depending on where a given company is in its particular e-commerce strategy). Still, with Amazon's dominant position in online retail ($48 billion in 2011 revenue, roughly equal to the next six closest non-auction competitors combined), bricks-and-mortar chains have a lot of catching up to do. With e-commerce sales at between 6% and 7% of total U.S. retail sales the past several months (according to the U.S. Census Bureau), we expect ongoing investments in e-commerce by nearly every retailer given the high returns and increasing interest from consumers to shop online. In addition to being a viable distribution channel, the Web has proven to be an effective, low-cost tool to gauge consumer demand.
We've also witnessed a notable increase in infrastructure and supply chain investments among consumer cyclical firms, most designed to bring products to the market faster. Additionally, retailers and restaurants continue to invest in new point-of-sale technologies as well as interior and exterior upgrades to help store locations stand out from a crowded landscape.
Costs of goods sold (transportation, commodity, wages) spiked during 2011, and while some remain at high levels (oil) and could still increase from here, the year-over-year impact in 2012 is poised to be less severe. In some instances (notably cotton) the price per pound has retreated more than 50% from mid-2011 peak levels. Most management teams have acknowledged that buying prices have come down meaningfully, though they were quick to note that the ultimate benefit likely won't appear in the financial statements until the back half of 2012. However, India's recent cotton export ban may also be a headwind, leaving consumer cyclical firms more vulnerable to another spike in cotton prices.
Share Repurchase Programs Set Stage for Earnings Outperformance
Fueled by aggressive cost-cutting efforts and conservative capital budgets, most consumer cyclical names have accumulated sizable cash stockpiles the past several years. On average, we forecast that cash and equivalents will represent approximately 20% of total assets for our consumer cyclical coverage universe at the end of 2012, which we believe to be an all-time high.
We doubt the market is willing to reward companies for sitting on this cash, so it's not surprising that an increasing number of consumer cyclical companies announced dividend increases and/or expanded their share repurchase programs as part of their year-end updates. This affirms our view that more retailers will opt to return cash to shareholders in the near term, given fewer attractive domestic investment opportunities. In our view, these trends will likely continue over the next year, and we wouldn't be surprised to see additional first-time dividends coming out of the consumer cyclical sector over the next several months.
Collectively, we're forecasting low double-digit earnings per share growth across our consumer cyclical coverage universe in 2012, which might seem somewhat aggressive in the context of our industry expectations for mid-single-digit comparable sales growth, low-single-digit unit expansion, and muted operating margin expansion. However, we are confident that consumer cyclical firms will be able to support aforementioned channel diversification, infrastructure investments, and other asset renovations while simultaneously buying back shares, indicating another strong year of earnings growth. Although this would seem to suggest lower-quality earnings per share growth, it still may be sufficient to satisfy already lofty market expectations and extend the category's recent stock price momentum.
Our Top Consumer Cyclical Picks
Following the recent market run, we peg the average price to fair value for our consumer cyclical universe at 1.05 (implying the category is 5% overvalued). There are few outright bargains, though we continue to focus on later-cycle categories such as home improvement, which may strengthen as the recession cycles. We would become more interested if the market were to trade down 10% or so, but we are quick to gravitate toward firms with established economic moats, which may be in a better relative position to withstand near-term revenue and operating margin volatility.
In general, we like companies possessing a combination of scale, pricing power in categories where perceived differentiation matters, exposure to emerging markets (particularly China), resources to extend brand reach, and strong dividend growth potential.
|Top Consumer Cyclical Sector Picks|
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|Data as of 03-26-12.|
High unemployment and lackluster corporate spending have hampered results, but we believe the market is underestimating the industry leader's ability to deliver strong performance as the economy improves. Staples continues to see gains in customer traffic and contract business, while its competitors are seeing similar declines.
American Eagle Outfitters (AEO)
Getting the right merchandise at the right price remains the hardest part of maintaining American Eagle's success. While we don't believe American Eagle has an economic moat due to nonexistent consumer switching costs, we expect the retailer to remain a solid player in a competitive category. New product line concepts and brand expansions from the firm could drive near-term growth, and we expect this to remain a focus as new CEO Robert Hanson takes the helm in 2012. Operationally, the company is implementing cost-sourcing initiatives to lower input costs and improve inventory turns, which will help it get fashion to market faster and remain very relevant in the specialty retail space. Additionally, we believe American Eagle meets the typical leveraged buyout target requirements of being a strong free cash flow generator with minimal financial leverage.
PayPal's in-store point-of-sale tests with several national retailers will renew the market's optimism for the company's payment processing capabilities, while momentum should continue in the marketplaces segment. We believe investors should draw their attention to management's updated 2013 segment target ranges, including an increase in 2013 revenue and segment margin targets for PayPal to $6.5-$7.0 billion and 25%-26% (previously $6.0-$7.0 billion and 24%-26%), while also lifting revenue expectations for the marketplaces ($7.5-$8.0 billion versus $7.0-$8.0 billion) and GSI Commerce ($1.2-$1.3 billion compared with $1.1-$1.3 billion) segments.
Time Warner (TWX)
Time Warner will benefit most from our thesis that quality content is king, especially through HBO Go as a customer retention tool and incremental licensing deals for its deep library of TV content. Time Warner has less earnings risk than its peers given its relatively low exposure to advertising, which we expect to decelerate in 2012.
Under Armour (UA)
We reiterate that we still like Under Armour's brand and products, but the current valuation implies more than 25% annual EBIT growth for the next decade without interruption. The cotton product has been gaining traction but still represents a small percentage of sales; we remain concerned about cannibalization. The stock price also assumes a steep growth curve in international markets and success in newer categories, like basketball footwear, which directly competes against larger players Nike (NKE) and adidas (ADS), which are less likely to cede share to Under Armour.
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R.J. Hottovy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.